Internal Rate of Return: A Simple, Non-Mathematical Explanation

Thomas C. Klein, Wilson Sonsini Goodrich & Rosati

How do venture investors compare investments in portfolio
companies when the amounts invested, the timing of those
investments, the returns, and the timing of those returns are all
different? The tool venture investors use to compare the rates of
return on each investment on an "apples-to-apples" basis is the
internal rate of return (also known as the compound annual growth
rate or CAGR).

A typical venture investment involves several investments into
a portfolio company at various stages of the company's
development. From an investment perspective, those investments
are considered negative cash flow; that is, cash going out from
the venture fund. Of course, the cash goes out from the venture
fund at different times. Investing $100 today is more expensive
to the venture fund than investing $100 in a Series C Preferred
Stock round three years from today because the venture fund would
only have to put aside, say, $80 today to grow into the $100
needed in three years for the Series C Preferred Stock
investment. This $80 is known as the discounted value or the
value in "today's dollars" of the $100 investment that would be
made in three years. Accordingly, any "apple-to-apples"
comparison of investments would have to compare investments based
on today's dollars.

Similarly, when the portfolio company is successful, cash is
returned to the venture fund. This is positive cash flow for the
venture fund. Obviously, it would be better for the venture fund
to receive the positive cash flow earlier rather than later for
the same reason the venture fund would prefer to have the
negative cash flow later rather than earlier. Receiving dollars
today is more valuable than receiving the same number of dollars
in the future, because if the fund receives the dollars today, it
can invest those funds and earn a return on them. Accordingly, an
"apples-to-apples" comparison of investments would have to
compare investments not just on when the dollars are invested and
how much those dollars are, but also on when the returning cash
is received and how much it is. Thus, if a venture fund is to
compare an investment into one portfolio company versus another,
it will want to compare those investments based on outflows of
cash in today's dollars and inflows of cash in today's
dollars.

If a venture fund projected its investments into a portfolio
company, and projected how much it would receive when the
portfolio company would get purchased or go public, and also
took into consideration when it made the investments and when it
would receive the returns, then the venture fund could
determine what rate of return it earned in today's dollars. Thus,
this calculation would reflect all of the investments and all of
the returns in today's dollars, and show the venture fund what
rate of return it would earn in that investment. This rate of
return calculation is called the internal rate of return, also
known as the compound annual growth rate.

Accordingly, the venture fund analyst takes the above
information and solves for the rate of return, rather than
knowing the rate of return and solving for value in today's
dollars of the investment. Thus, the cash outflows and inflows,
in today's dollars, determine the rate of return. With this in
mind, it is easy to see that in order to calculate the internal
rate of return, all that the analyst needs to know or assume is
the amount of money to be invested and when (and it might be
lumpy; that is, different amounts invested at different times),
and the amount of money assumed to be returned and when (and this
too may be lumpy).

Timing Is Something...but not Everything

Accordingly, the timing of the fund's investments and the
timing of the receipt of the returns of cash are crucial
determinants of whether the investment should be made. If the
fund invests a lot today and a small amount later, then the fund
will have its money in the company at risk longer and therefore
will not have the opportunity to use those funds to earn a return
elsewhere. It is not the same to the venture fund if it makes its
entire investment in the company right away instead of staging
its investments over time. Therefore, even if the total
investment amount would be equal and the final payments back to
the venture fund would be equal in each case, the timing of the
investments would be important in determining whether the
investment was a good one or not compared to other investments
available to the fund.

Timing is also important with regard to the ultimate funds
received when the investment is liquidated. The venture fund
would definitely prefer to receive its returns earlier rather
than later, and depending on the circumstances, the fund would
accept a smaller return if it is received earlier. Thus, the
internal rate of return informs the venture investor that the
smaller the early round investments and the earlier the returns
are generated (assuming the early returns are equal in amount to
the later returns), the better the internal rate of return. That
is fairly intuitive.

For example an investment of $100 that returns $100 in
earnings plus the $100 capital invested in one year is a much
better investment than if the returns are received in fifty
years. The question is how much better of an investment is it -
and the internal rate of return can answer that question.

The Internal Rate of Return: Putting Dollars and Timing
Together

The internal rate of return informs an investor of the rate of
return of the investments made based on how much was invested,
when it was invested, how much was returned, and when the return
was received. Thus, if several investments are made at different
times, like venture fund investments in a portfolio company at
the time of different rounds of financing, the internal rate of
return informs the fund managers of the rate of return for the
total of the investments based upon when those investments were
made and when the returns were, or are expected to be, received.
It even works if the returns are spread over time as well.
Therefore, for complicated staged or lumpy investments, or for
those that return periodic payments or returns (like a bond),
calculating the internal rate of return can allow a venture fund
to compare that investment to other similar staged or lumpy
investments to see which one actually offers the highest compound
annual growth rate, the internal rate of return.

For example, if a venture fund makes an investment in a
portfolio company's Series A financing today, makes an additional
investment in the company's Series B financing one year later,
makes a final investment in the company's Series C financing 20
months after that, and the company is expected to be sold or go
public at three years from the Series C investment, the investor
can compare that investment to others in the venture fund's
portfolio by using the internal rate of return.

Rather than just compute the difference between the final sale
proceeds of the investments and the sum of the amounts invested,
which would be the total profit, and then divide the profit by
the total amount invested (which would provide a total percentage
return), the internal rate of return uses time to determine the
rate of return needed for the investments to equal returns
generated. That is why the internal rate of return is sometimes
referred to as the compound annual growth rate - the rate at
which lumpy investments grow to equal the final returns.

So What?

The power of the internal rate of return is that it allows an
investor to compare different investments, because the internal
rates of return incorporate timing - when the investments are to
be made and when the returns are expected to be received. That
is, the magic of the internal rate of return is that it allows an
investor to compare the rate of return on different investments
in today's dollars. Taking the example above about a $100
investment returning $100 plus the capital invested in either one
year or fifty years, the only difference was when the returns
were received. In both cases, the total percentage return is 100%
($100 profit on $100 invested), but the internal rates of return
are much different. For the investment returning all capital and
profit in one year, the internal rate of return is 100%; for the
investment returning capital and profit in fifty years, the
internal rate of return is 1.4%.

Advantages

The main advantage to computing the internal rate of return on
venture investments is to compare investments that have uneven
investments or uneven cash flows. In addition, in the venture
capital world, the internal rate of return can be the springboard
to other useful calculations, such as calculating the value that
the portfolio company must attain in order to generate the
internal rate of return required by the venture fund. The fund
analyst can then determine if that is realistic given the
expected size of the company's market.

Disadvantages

The main disadvantage to relying too heavily on the internal
rate of return as a guidepost for investing is that it does not
account for the relative risk of the investment. Although the
calculation can allow an investor to compare a variety of
investments on a strict returns analysis, the internal rate of
return does not address the relative risk, and that must be done
with other tools.

Accordingly, in venture capital, a biotechnology and an
enterprise software investment can be compared using the internal
rates of return for these investments, but the risk of the two
investments may be quite different.

Conclusion

The internal rate of return is one of the most useful metrics
for evaluating investments in the venture capital area, but it
does not account for risk. In venture investing there is a large
universe of risk: risks in development, competition, and
recruiting and retaining key employees, to name a few. Although
the internal rate of return is useful in making a "go - no go"
decision on an investment, it is not a substitute for the
experience of the venture capitalist.